A recent cover of The Economist featured a city map broke by a deep chasm separating Wall Street from Main Street with the headline “A Dangerous Gap: The Markets Versus the Real Economy.” The magazine was calling attention to the fact that global stock markets have been rallying while the world economy is still reeling from the effects of the coronavirus.
The gap has emerged in Israel, too. The main share indices on the Tel Aviv Stock Exchange have risen 20% to 30% since their low on March 23. The index of inflation-linked government bonds has climbed 11% and the shekel bond index by 4%. Both are now close to their pre-pandemic highs. Meanwhile, the shekel has recovered nearly all its coronavirus losses against the dollar.
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Meanwhile, the real economy is facing a massive recession. Gross domestic product dropped at a 7.1% annual rate in the first quarter. Consumer spending was down at a 20% rate, investment down 17% and exports 9.5% lower. Unemployment (including people on unpaid leave) soared to 30% and that number is expected to remain at an elevated 10% through the end of the year.
Of direct interest to the bond market, the government is expected to run a budget deficit of 10% of GDP or more this year and public debt is forecast to rise to 71% of GDP from 60%.
Economists have been warning that stock market rallies in Israel and worldwide have gone too far, too fast. They reflect an unrealistic assumption about how quickly the real economy will recover from the coronavirus. The markets, they say, are due for a correction, maybe even a massive one, later this year.
“Investors right now are trading on hope and expectations, but they should be adopting a more cautious attitude. Through the rest of the year, economic activity will probably be low relative its pre-crisis levels, if what we’re seeing in Asia countries that have already exited the coronavirus,” said Alex Zabezhinsky, chief economist at the Meitav Dash investment house.
“There are no economic data that can explain the [markets’] rise. The numbers are mainly wishful thinking,” added Jonathan Katz, chief economist at Leader Capital Markets.
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In normal times, friction between China and the U.S. – the escalation of the trade war, remarks by the U.S. President Donald Trump and China’s rescinding Hong Kong’s special status, would have had a strong impact on the markets, Katz said. Likewise, the protests in U.S. cities. But all these events have been shrugged off, he said.
“Investors are seeing everything through rose-colored glasses – that from now on everything can only get better. They are looking forward. They aren’t looking at the deep recession and are pricing in for a big recovery. They aren’t considering a second or third [coronavirus] wave or the rate of contagion continuing at its current rate. They see the economy opening up, whether or not there’s a vaccine,” explained Katz.
“I’m not convinced. If a vaccine really is developed, the number of cases will drop and the economy will reopen and the markets will have been correct. But there’s another likely scenario of growing contagion rates in the U.S. and the crisis deepening,” he warned.
Rafi Gozlan, chief economist at IBI investment house, takes the same view.
“The market isn’t pricing in a second wave or expecting one. It’s also not pricing in existing risks – on the one side, the real damage coming from continued high rates of unemployment, and on the other, political risks, such as tensions between the U.S. and China and the U.S. election,” said Gozlan.
“Right now, investors believe the odds of these risks becoming real are small. But these risks could materialize in another quarter or two, at which point the market will price them in all at once,” he said.
Gozlan noted that when the market realized in February that the coronavirus was a major event, it reacted immediately. Under the circumstances, he said, he would have expected investors now seeking a higher risk premium ahead of other bears suddenly emerging.
Economists attribute the market rally not just to excessive bullishness. Money has been pouring into them from the massive government aid programs set up to counter the economic impact of the pandemic while central banks have undertaken expansionary monetary policies.
“In the U.S., the Federal Reserve is buying bonds from everyone, even corporate junk bonds … It has set no limits. The injection of capital form the background for the positive markets,” said Katz.
Zabezhinsky noted that in April, U.S. household income reached a record high – not because people were working but because government aid was more than three times the amount of income lost from not working. Since people were under lockdown they spent less; he said he believed that at least part of the savings found its way to the stock market.
Gozlan explained that “what drives the stock market is liquidity mainly. At the start of the crisis, the market suffered from a lack of liquidity and big mutual fund redemptions. These two developments led to the positive phase – mutual funds began raising money and the support of central banks. In a normal situation without the liquidity injection, the market would be pricing risks in a different way.”
In the TASE, said Zabezhinsky, investors have been taking heart from the latest economic data, which have pointed to a return to normal economic activity, in spite of the continued health crisis.
The data on a quarterly or monthly basis don’t provide good enough resolution to see ahead because the situation is changing so rapidly. Everyone, including the Bank of Israel, is focusing on the most up-to-date data, such as credit card transactions, electricity usage and the Google Mobility Index, he said.
These data show that the [Israeli] economy is recovering very quickly. Daily credit card purchases, as of May 25, were much higher in many categories than they were in January and February, for instance, purchases of electronics products, furniture and apparel, noted Zabezhinsky.
“The takeaway is that the economy is exiting the crisis relatively quickly, both in Israel and in the other Western countries – and that opens the door for optimism,” he said.
“The question is what will happen later on. If you look at countries that are further along on the road to the ‘coronavirus normal,’ like Korea, Vietnam and China, the economic data are weak. Activity has stabilized at a lower level than they were before the crisis,” Zabezhinsky warned. “The stock market’s problem is likely to come when we see economic activity stabilizing but at low levels.”
In any case, said Gozlan, not all sectors of the stock market have rallied equally. The sectors that have done well, such as high-tech, healthcare and basic consumer products, are relatively immune from the coronavirus downturn. Others, such as industry, financial services, and real estate, have not done as well.
That said, Gozlan said the markets’ upside is limited so long as the industrial and financial sectors don’t recover. That’s not the case for real estate.
“There is a big question mark about real estate the day after the crisis. The coronavirus exposed a fundamental change – the ability to give up on offices and work from home. That was a once-in-a-lifetime experiment that raised the option of remote work. The big casualty of this could be the commercial real estate sector. It’s hard to see the situation not changing,” said Gozlan.
Despite the crisis, the Israeli economy got a vote of confidence from Standard & Poor’s three weeks ago when the credit agency affirmed the country’s AA-minus rating and Stable outlook. That report went a long way to enhancing investors’ confidence in Israel’s ability to cope with the crisis.
Zabezhinsky, however, is adopting a cautious attitude about how the Israeli economy will be looking later in the year.
“I believe at a certain stage we’ll see economic activity stabilize and then we’ll see that it’s at a low level. From the stock market’s point of view, that will be the test: Investors will start pricing in future profits and will adjust prices to the state of the real economy,” he predicted.
Further down the road, Zabezhinsky said there was room for more optimism “When they find a permanent solution for the coronavirus, we’ll see a more rapid recovery of the market. I hope that will be within the year and, if so, we can talk about faster [economic] growth in 2021.”
Gozlan said he was predicting a longer and more drawn-out recovery, with an extended period of relatively high joblessness. As long as there isn’t a clear medical solution, consumer spending will be conservative and cautious as will be corporate investment.
“We’re likely to see waves – some opening, with restrictions and restraints. It’s a new reality and when people see that we’re not in a normal situation, they’ll pull back. As much as government support is forthright, the economic situation will be better,” Gozlan said.